The Costs of Production Chapter 8!

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1 The Costs of Production Chapter 8!

2 Implicit Costs vs. Explicit Costs Implicit costs - the opportunity cost that is equal to what that has to be given up by a firm for using factors that it neither hires nor purchases. Example; rent, wages, interest Explicit costs - Explicit costs are the direct payments that are given to others while running a business like rent, wages, materials. Example; sticks, sandpaper, labor, electricity.

3 Simple Example Cost of going to the movie? Accountant 8.00 Ticket Pop and popcorn (EXPLICIT COSTS) Gas = Accounting Costs Economist 8.00 Ticket Pop and popcorn (EXPLICIT COSTS) Gas lost wages (IMPLICIT COSTS) = ECONOMIC COSTS

4 Accounting vs. Economic Profits Accounting Profit = TR - Explicit Costs Economic Profit = TR - Explicit Costs + Implicit Costs

5 What is a Normal profit? Is a component of implicit costs and often defined as the opportunity cost of using entrepreneurship in production of a good or service. (The Opportunity Cost of your choice of Business) Example; If you were not making diamond willow walking sticks, what was the next best use of your entrepreneurial skills? This cost should be included in your implicit costs when calculating your total economic costs of production.

6 A more complex example Diamond Willow Walking Stick Price = $50.00 Quantity = 1000 Total Revenue = $50,000 Costs Sticks $10,000 Labor $10,000 Sand Paper $1,000 Lacquer $1,000 Stick Strippers $1,000 Utilities $5,000 Total Explicit Costs $28,000 Accounting Profit $22,000

7 Total Revenue= $50,000 Implicit Costs Forgone Rent $5,000 Forgone Interest $500 Forgone Entrepreneurial Income $30,000 Total Implicit Costs $35,500 Total Explicit Costs (previous page) $28,000 Economic Profit $-16,500 What if you were earning zero economic profit? Are you really earning 0 dollars?

8 Short Run Production Costs Fixed Costs! -Costs that incur when producing nothing! (total fixed costs = overhead)! ex. rent, interest, taxes, insurance, machinery (Plant)! AFC =TFC Q Average Fixed Cost Curve

9 Variable Costs! -Costs that change with changes in output.! ex. Labor - Raw materials! AVC=TVC Q Note: the average variable cost curve is U-shaped

10 Total Costs! -Sum of fixed and variable costs! F ixed + V ariable = T otal

11 Average Total Costs! AVC + AFC = ATC or TC/ Q! Note: the average total cost curve is U-shaped

12 Marginal Costs! -The cost incurred by producing one more! unit of output. (Allows the seller to determine profit ability! of increasing or decreasing the production of! one more unit.)! MC= TC or VC Note: the marginal cost curve is U-shaped

13 Marginal Cost is the change in TC or VC

14 Example of Costs in the Short Run

15 A graphical example of the SR Cost curves from the previous page

16 What does the distance between the ATC and AVC represent?

17 Note: Total Cost curves are very different than average cost curve.

18 Note: The marginal cost curve intersects the average cost functions at the very minimum of the average functions. Why?

19 Why are the Average and Marginal Cost curves U-shaped? Diminishing Marginal Return -As one more resource, such as! labor, is added the output per unit of input may increase initially,! but eventually the rate of productivity will decrease.! What must be added in the short run to increase quantity?

20 Total Physical Product Curve total product is the total quantity or output of a particular good or service produced Assuming our plant capacity is fixed, notice that to increase the quantity of jackets the firm must add a variable Labor.

21 Marginal Physical Product the additional output per unit of input (labor) MPP = in total product Average Physical Product (labor productivity) output per unit of input. APP = TP/Units of Labor Laborer TP MPP APP

22 TPP, MPP, and APP together in one graph

23 The marginal productivity curves are a mirror image of the average cost curves. Thus DMR explains U shaped cost curves. As you add more labor to increase output, at first average cost curves fall and then rise.

24 Short Run Costs Costs in the Short Run represent diminishing returns at some point of production as the output of a good or service increases.!

25 Long Run Costs Costs in the Long Run represent increasing returns when firms utilize specialized machinery and labor, mass production, and technology (manna from heaven) to achieve Economies of Scale - a reduction in costs resulting from large scale production (all costs are variable in the long run)!

26 Note: in the short rung the firm faces diminishing returns, however in the long run the firm faces economies of scale. What may cause Diseconomies of Scale?

27 SUNK COSTS -Costs that have already been incurred and can t be recovered to any significant degree. Ex. *The fact that you already paid for a good or service, shouldn't t play a part in your rational decision making. -You feel ill, but you already paid $200 dollars for a Vikings ticket, should you stay home or go to the game? -DON T CRY OVER SPILLED MILK!!!!